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Milwaukee Metro Area

Second Quarter 2008

FIRMS RELOCATING TO DOWNTOWN FROM MILWAUKEE SUBURBS
The Milwaukee economy is undergoing a change from manufacturing to more service-oriented industries, but the transition will take several years. In the near term, operating fundamentals will record mixed performance as employers shed jobs and new construction increases. As a result, elevated vacancy levels are expected to hamper rent gains over the next few quarters. There are bright spots, however, such as the Downtown submarket, where local companies like Roundy and Manpower are moving in from the suburbs. During the past five years, residential development has been brisk, particularly in and around the Third Ward. Indeed, this elevated construction activity is expected to continue to lure business relocations from the metro’s outlying areas, which have been particularly hard hit by ongoing job cuts. In the investment arena, tightened lender requirements have slowed transaction velocity during the past 12 months. This deceleration is expected to continue as fundamentals soften this year. The historical consistency of Milwaukee’s economy has resulted in a steady contingent of out-of-state buyers targeting premium properties with long-term leases, which currently trade with cap rates in the low- to mid-7 percent range. Local buyers, on the other hand, have sought upside potential in Class B/C properties in traditionally high-growth areas, such as the West Waukesha County and Wauwatosa/West Allis submarkets. Cap rates for these assets are hovering in the mid- to high-8 percent range. Looking ahead, properties in the city core will continue to garner intense interest, while assets in suburban areas may need to be priced conservatively to avoid prolonged marketing times. Class A cap rates are expected to push only modestly higher in the next few months, but below-average performance of metrowide fundamentals will likely result in Class B/C yields recording more significant increases.

2008 ANNUAL OFFICE FORECAST
0.7% decrease in total employment

Employment: After expanding 0.1 percent in 2007, Milwaukee-area payrolls are expected to contract 0.7 percent this year as approximately 5,700 jobs are eliminated. Office-using sectors are projected to trim nearly 1,400 spots, also a 0.7 percent reduction.

900,000 square feet will be completed

Construction: Developers are on pace to add 900,000 square feet of office space to the Milwaukee metro this year for a 3 percent stock increase, following a 0.5 percent gain in 2007.

210 basis point increase in vacancy

Vacancy: Reduced tenant demand and increased completions are expected to push vacancy up 210 basis points to 15.8 percent in 2008, after the rate improved 60 basis points last year.

0.4% increase in asking rents

Rents: Owners are anticipated to respond to decreased occupancy levels by slowing rent expansion this year. Asking rents are expected to gain 0.4 percent to $19.08 per square foot, while effective rents recede 1.6 percent to $15.24 per square foot.

ECONOMY
3%
Year-over-Year Change

Employment Trends
Nonfarm Office-Using

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Employers have generated just 140 jobs during the last year, while payrolls have been trimmed by more than 1,000 positions over the past two quarters. Office-using employment has thinned by 1.6 percent, or approximately 3,000 jobs, in the last 12 months, following a 2 percent expansion in the preceding period. Current losses have been heaviest in the professional and business services sector, which has lost more than 2,000 workers during the past year. Diminished home equity refinancing and rising fuel prices have led to a decrease in Harley Davidson sales. In an effort to cut costs, the company will lay off nearly 750 Milwaukee-area employees, including 360 office-using positions. Outlook: After expanding 0.1 percent in 2007, Milwaukee-area payrolls are expected to contract 0.7 percent this year as approximately 5,700 jobs are eliminated. Office-using sectors are projected to trim nearly 1,400 spots, also a 0.7 percent reduction.

Approximately 470,000 square feet of office space has come online during the last 12 months, expanding metro inventory by roughly 1.7 percent. This follows the completion of 18,000 square feet in the previous period. Just under 600,000 square feet is under way throughout the metro. Building activity in the Greenfield/South Milwaukee County submarket is brisk, as 85 percent of all current construction is located in the area. In addition, 65 percent of the planning pipeline is slated for the submarket. New mixed-use developments in the downtown area have come to prominence lately. One project, the 40,000-square foot Pabst Boiler House building of the Brewery redevelopment, broke ground in the first quarter this year. Three companies are expected to move in upon completion in the fourth quarter of this year. Outlook: Developers are on pace to add 900,000 square feet of office space to the Milwaukee metro in 2008 for a 3 percent stock increase, following a 0.5 percent gain last year.

Metrowide vacancy increased 150 basis points year over year to 14.7 percent in the second quarter. Elevated deliveries in the first half of this year contributed to the rise. Additions to premium inventory during the past 12 months resulted in Class A vacancy climbing 170 basis points to 12.7 percent in the second quarter. As completions accelerate in the second half of the year, vacancy in this segment is projected to escalate. Competition from new space spurred a 280 basis point increase in lower-tier vacancy over the past year to end the second quarter at 17.7 percent. Outlook: Reduced tenant demand and increased completions are expected to push vacancy up 210 basis points to 15.8 percent in 2008, after the rate improved 60 basis points last year.

16% 14% 12%
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04

05

06

07

08*
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* Forecast Sources: Marcus & Millichap Research Services, Reis

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Marcus & Millichap

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Office Research Report

RENTS
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Year-over-Year Change

On a year-over-year basis, asking rents climbed 2.1 percent to $19.09 per square foot in the second quarter. Increased competition from new space caused existing owners to raise concessions, resulting in a 0.8 percent gain in effective rents to $15.40 per square foot. Asking rents in the metro’s upper-tier properties ended the second quarter at $22.96 per square foot, 1.7 percent higher than in the same period last year. Class B/C rents advanced 2.6 percent to $16.07 per square foot. The jump in vacancy during the second quarter, combined with slowing effective rent gains, softened year-over-year revenues 1.2 percent; in the preceding 12-month period, revenues increased 7.5 percent. Outlook: Owners are anticipated to respond to decreased occupancy levels by slowing rent expansion this year. Asking rents are expected to gain 0.4 percent to $19.08 per square foot, while effective rents recede 1.6 percent to $15.24 per square foot.

6% 4% 2% 0% -2%

Rent Trends
Asking Rent Effective Rent

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04

05

06

07

08*

* Forecast Sources: Marcus & Millichap Research Services, Reis

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SALES TRENDS**
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Transaction velocity has declined 14 percent during the most recent 12-month period, driven largely by difficulty for prospective buyers to obtain financing. Despite the slowdown in sales activity, the number of deals involving uppertier space has increased recently. As such, the median price has appreciated roughly 15 percent to $111 per square foot over the past year. Cap rates have remained relatively stable in the mid- to high-7 percent range for the last two years, slightly higher than other Midwestern metros. Yields will likely trend upward as the cost of capital remains elevated. Outlook: While investment activity may moderate further through the second half of the year, buyers with market knowledge will likely continue to target assets with repositioning or value-add opportunities, particularly in the suburbs.
Median Price per Square Foot

Developers have added two projects with nearly 77,000 square feet of medical office space to the metro during the past year, compared with no completions in the previous period. There are currently no developments under way and 660,000 square feet in the planning stages. Absorption of medical office space has slowed over the last 12 months. As such, vacancy in this sector ended the second quarter at 5.3 percent, 20 basis points higher than in the same quarter last year. Asking rents for medical office space finished the second quarter at $16.42 per square foot, a year-over-year gain of 1 percent. Buyers have displayed flight-to-safety patterns recently, accelerating sales activity for medical office properties over the past 12 months. As a result, the median sales price has increased 3 percent in the last year to $186 per square foot. As the metro’s population remains older than the national average, interest in medical office space is expected to intensify, which will likely generate further appreciation for medical office space.

The Federal Reserve held the fed funds rate at 2 percent during its June meeting. The Fed had cut the rate by 275 basis points since last September, but the potential for inflation stemming from elevated food and energy prices remains a concern. Office mortgage originations in the first quarter were down 75 percent from one year earlier and 21 percent below the previous quarter. Much of the decline was driven by conduits, which recorded a 96 percent year-over-year decrease in originations. Lenders remain cautious, resulting in lower loan-to-values (LTVs) and higher debt-service coverage ratios (DSCRs). On average, LTVs are at 60 percent to 70 percent, while DSCRs are 1.20x to 1.30x. Portfolio lender spreads for office properties are currently 175 to 250 basis points over 10-year swaps. Several major conduits are talking about re-entering the market in the second half, but pricing is the immediate barrier to coming back into the market. The yield on the 10-year Treasury rose to 4.2 percent in June but has since dropped to 4 percent. Through the rest of this year, the yield on the 10-year Treasury is expected to remain in the high-3 percent to mid-4 percent range.

A 95,000-square foot medical office facility is expected to break ground in the North Suburban submarket this summer to alleviate excess demand at the nearby Orthopedic Hospital of Wisconsin. The project may spur additional construction activity and ultimately lead to a medical office/research campus in the area. Office space in the Downtown submarket is poised for long-term health. Several large companies have recently announced plans to relocate to the area, leasing a total of nearly 100,000 square feet. During the past 12 months, the Greenfield/South Milwaukee County submarket has posted the metro’s largest increase in effective rents. Tight conditions have allowed owners to trim concessions and raise effective rents by nearly 9 percent in that time. Significant supply additions this year, however, will hamper attempts to maintain occupancy levels.

Notes: Employment growth is calculated using seasonally adjusted quarterly averages. Construction, rent and vacancy figures exclude build-to-suit, flex-space and medical office properties unless otherwise noted.
The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, express or implied, may be made as to the accuracy or reliability of the information contained herein. Sources: Marcus & Millichap Research Services, Bureau of Labor Statistics, CoStar Group, Inc., Economy.com, Property & Portfolio Research, Real Capital Analytics, Reis, Torto Wheaton Research Services.